ECONOMICS
NOTES ON MONETARY POLICY
What is money? It has three functions and anything that fulfills these requirements is money… 1. is a medium of exchange - useful in buying goods and services, is a readily acceptable form of payment In the past money has been shells, cows, even fishooks 2. is a measure of value - is a convenient measure for determining the relative worth of goods and services. Barter, while useful to some degree, does not accommodate comparisons of unsimilar goods and services. 3. store of value - it is the most spendable of all forms of payment. Its easy to collect and physically store.
The Three M’s
M1 = currency ( coins and paper money) + checkable deposits (deposits in commerical banks/s&Ls) coins make up only a small part of the total money supply 2or3% of the 866 billion M1 supply paper money makes up about 28% of the economy’s M1 money supply. (240 billion or so, all in the form of Federal Reserve Notes) checkable deposits are checking accounts. They are a convenient way to pay especially large debts. It has become the dominant form of money in our economy and represents the transferring of ownership of deposits in banks from one person to another.
M2 and M3 Near - monies are highly liquid financial assets such as savings accounts, time deposits, and short term government securities. They can be readily and without risk of financial loss be converted into currency or checkable deposits. A time deposit are only available to the depositor at the time of maturity. For example a 90 day or six month deposit is only available without penalty when the designated period expires. Money market accounts are interest bearing accounts that are investments in short term securities. They have minimum balance requirements and limit how often money may be withdrawn. Money market mutual funds are offered through financial investment companies. They usually contain the combined funds of mutual shareholders to buy short term credit instruments such as CDs and US government securities
therefore M2 = M1 + noncheckable savings deposits + small (less than 100,000) time deposits + MMDA’s and MMMF’s
M3 = M2 + large (100,000 or more) time deposits - usually owned by businesses in the form of CD’s
CREDIT CARDS ARE NOT MONEY, THEY ARE SHORT TERM LOANS FROM THE BANK THAT ISSUED THE CARD.
WHAT BACKS THE MONEY SUPPLY? The major components of the money supply ( paper money and checks) are debts or promises to pay. Paper money is the debt of the Federal Reserve banks and checks are the debts of commercial banks and savings and loans, credit unions.
Paper money and checks have no real intrinsic value. The $5 bill is only paper . You cannot redeem this piece of paper for anything tangible like gold. SO WHY DOES IT HAVE VALUE? 1. acceptability - we allow them to have value by agreeing to accept them. 2. legal tender - it is a matter of law. This means that paper currency must be accepted in the payment of a debt or the creditor loses both the right to charge interest and the right to sue the debtor. The paper dollar is money because our government says it is. This is called fiat money because it is not redeemable in terms of some precious metal. 3. Relative scarcity - the value of money is basically a supply and demand function.
WHO CONTROLS THIS SUPPLY OF MONEY?
Our historical roots are filled with centralization of the money supply in spite of trends in recent decades to deregulate such as the Depository Institutions Deregulation and Monetary Control Act of 1980. It reduced or eliminated many of the historical distinctions between commercial banks and S &Ls.
It became evident very early in our history that a centralized money supply was essential for an efficient banking system. One of the main problems in the government under the Articles of Confederation involved the differing monetary systems of the states. 1. Everyone had to agree to accept each other’s money and 2. control the supply This of course did not work. An unusually bad money panic in 1907 finally convinced Congress that a National Monetary Commission was need to examine the problems of regulating the supply of money. The end result was the Federal Reserve Act of 1913.
Monetary policy is the control of the money supply in the economy in order to combat the problems of inflation and unemployment
AP DEFINITION (the fundamental objective of monetary policy is to assist the economy in achievieng a full-employment, noninflationary level of total output.)
Credit and money are both goods for which the laws of supply and demand hold true. Credit also has a cost, the interest rate charged for the use of the money borrowed. As the cost of borrowing increases the demand for loans decreases.
The United States banking system is based on fractional reserve banking.
Fractional reserve banking means that only a fraction of the daily deposits a bank receives remain on hand. The rest is loaned to individuals and businesses or invested by the bank, for example in treasury bills.
Since 1913, the Federal Reserve has set specific reserve requirements for all banks.
The reserve requirement is that percentage of deposits that the bank must retain on hand and not lend. This can reside in the banks vault or be deposited in a Federal Reserve Bank.
Currently, the reserve requirement may be varied from 3 to 14 % on demand deposits (Checking accounts) and between 0 and 9% for time deposits ( savings accounts )
Money Expansion The money supply increases each time it is deposited and reborrowed by those seeking credit. This can be illustrated as follows:
Round 1 You find 1000 in your backyard which has been buried for many years. After checking with the police it is determined that you may keep the money.
you deposit the 1000 in your bank (bank A) the bank has a reserve requirement of 20% This means that the bank must keep 200 of the 1000 dollars. It may then lend the other 800 to someone to start or add to a business.
Round 2 Bank A decides to loan the 800 to John Jones who wants to buy a piece of equipment for his business. John buys the machinery from Jackson's Machine Supply.
Jacksons has an account with a different bank, (bank B) They deposit the 800 in their bank. Bank B's reserves then increase by 800. Of this amount 20% (160) must be kept in reserve and the other 640 are excess reserves which may be loaned to others.
Round 3 Bank B loans the 640 to Mrs Wang and she in turn buys from Mr Dias who does banking a bank C. Bank C reserves 20% of the 640 deposit (128) and lends the rest (512) to Mrs. Fontana who buys from Mrs Powers and so on.
The end result is that a deposit of 1000 has grown to 5000 (eventually) ORGANIZATION OF THE FEDERAL RESERVE
The Federal Reserve is a system or network of banks. Power is not concentrated in one central bank but is shared by a governing board and 12 district banks
Open Market Committee Board of Governors Federal Advisory Seven members of Fed Res Bd + 7 members appointed Council Presidents of Fed Banks by the President with 12 prominent Set the system’s policy on the confirmation of the commerical bankers, purchase and sale of Senate; 14 yr terms one selected government bonds in the open staggered so one annually by each of market member is replaced the 12 district banks; every 2 yrs. meets periodically but has no real power
Twelve Federal Commerical Thrift Institutions Reserve Banks Banks Savings and Loans 12,453 2250 25 branches Mutual Savings Banks 366 Credit Unions 14,141 The Public households and businesses
Board of Governors - 7 member board appointed by the President and confirmed by the Senate term of office - 14 years and staggered so that one member is replaced each two years. Board exercises general supervision and control over the operation of the money and banking system of the United States. The Chairman of the Board is the most powerful central banker in the nation.
Federal Open Market Commitee - Helps the Reserve Board in policy decisions. Made up of the seven board members plus five of the presidents of the Federal Reserve banks They set the policy on the purchase of government bonds in the open market
Federal Advisory Council - twelve prominent commercial bankers, one selected annually by each of the 12 Federal Reserve Banks. It has no policy making powers - only gives advice
The Fed is an independent institution which cannot be abolished or rendered ineffective by presidential action or its functions be altered by Congress, unless specific legislation is passed.
The independence of the Fed is a matter of controversy some fear the power which has been given will be misused. Others believe it is very important that some control be exercised objectively, free from political stresses. The Twelve Federal Reserve Banks
Have three characterstics 1) central banks 2) quasi-public banks 3) banker's banks
Central Banks - basic policy directives of the Board are made effective through these 12 banks. There is one in each of the 12 districts. Atlanta is the Fed. Reserve Bank for our district which includes part of LA, part of MS, all of Al, part of TN, all of GA and FL
Quasi-Public banks - the 12 Federal Reserve banks are owned in part by private investment of commerical banks and public ownership of the Federal Government. These banks are not motivated by profits, as are private enterprises. All commercial banks who are part of the system must invest in the Federal Reserve.
Bankers banks - The Federal Reserve serve as the source of funds for commercial banks and a depository for their reserves. They also issue currency and are the lone source of new money for the economy.
Functions of the Fed 1. Reserves - repository of banks reserves 2. check collection - all checks are processed through the Federal Reserve banks. 3. fiscal agents - bank for the government (where they issue their checks from) 4. supervision - supervise the member banks' operations 5. control of the money supply - this is the major task of the Fed.
TOOLS OF THE FED - MONETARY POLICY
1. open market operations 2. changing the reserve ratio 3. changing the discount rate
1. open market operations the buying and selling of government securities Fed buys to infuse money into the economy sells to take money out of the economy
2. raising or lowering the reserve ratio
3. changing the discount rate - the interest rate charged to member banks who borrow from the fed
Easy money and tight money policy
1. Easy money - for recessions buy securities lower reserve requirement lower discount rate
2. Tight money - for inflation sell securities raise the reserve req. raise the discount rate